Peering into the Permanent Portfolio

On Monday I introduced the Permanent Portfolio, an investment strategy created in the early 1980s by Harry Browne. It calls for investors to hold equal amounts of stocks, long-term government bonds, gold and cash. I recently spoke to Craig Rowland, the blogger behind Crawling Road, to learn more about the ideas behind the Permanent Portfolio.

What attracted you to the Permanent Portfolio?

CR: My background is computer security, so when I test something I always start by trying to break it. And when I looked at traditional index fund portfolios, I noticed there were periods of time where they basically broke. By that I mean they either had significant declines, or they had extended periods where they didn’t have real returns after inflation. I noticed, for instance, that during the entire decade of the 1970s, a stock/bond portfolio didn’t even beat inflation. And I noticed that in other countries that type of portfolio failed over protracted periods of time. So I became convinced that the traditional idea of asset-class correlations was incorrect.

So I started looking at Harry Browne’s Permanent Portfolio, and honestly, at first I thought the guy was nuts. This idea of holding 25% of your portfolio in gold—I almost ignored everything he had to say. But I when I looked at the results and the economic underpinning of it, I said, “This guy is right.” What I mean is that he didn’t pick asset classes because they had some past correlations between each other. He picked the asset classes based on economic cycles, and that is really the secret.

I think one of the biggest wastes of space in financial books are pages and pages of asset class correlation tables. It is such a complete waste of information, because they don’t mean anything. People are puzzled as to why asset class correlations change over time. Well, they’re looking at the wrong pieces of information: the only correlation that matters is how that asset responds to what is going on in the economy. That is the only conclusion you can possibly reach.

So the idea is not that long-term bonds go up because stocks go down. It’s more correct to say that the economic conditions that cause stocks go down have some overlap with the economic conditions that cause long-term bonds to go up.

CR: Exactly. And it’s not black and white: there are periods when economies are transitioning from one cycle to another and there is this murky area where the markets try to figure out what the heck is going on. In the fall of 2008, this is what happened. The stock market was collapsing and the long-term bonds didn’t pick up immediately: it took some time before the markets collectively realized that deflation was in progress. At that point, the long-term bonds went up over 30% by the end of the year. It wasn’t instantaneous—there is always this lag time.

That’s why I tell people not to look at their portfolio every day. I don’t look at mine very often: people would be very surprised at how rarely I look at my portfolio. The more you look at it, the more pain you are going to experience. Just let the asset classes do what they do.

The remarkable thing about the Permanent Portfolio is not so much its average annual return, but its low volatility. According to the historical returns on your website, it would have had negative returns only twice in 40 years.

CR: You’re right, the volatility is very low, and this is something that Harry Browne noticed as well. He worked in the financial industry and he knew that volatility scares people off their investment plan. If you can have a portfolio that has lower volatility, even if it might have lower returns, you’re more likely to stick with it. And if you stick with it, those lower annual returns are probably going to deliver better long-term results than a very volatile portfolio, because when people experience big swings up and down, they’re probably going to quit. Or they are going to sell out at the wrong time and miss the recovery.

Having low volatility in a portfolio should not be underestimated. It’s very important, if only for your own sanity. You want to be able to control your emotions, and the Permanent Portfolio with its low volatility, I think helps control investor emotions. That is just as important as overall returns. It is easy to look at a spreadsheet and get excited, but when you are living through that market where you have 20%, 30%, 40% losses, but spreadsheet is not going to help you much.

The asset mix in the Permanent Portfolio really is a remarkable example of Modern Portfolio Theory in action, because you’ve achieved this very low volatility in the overall portfolio by using three extremely volatile asset classes.

CR: I think Harry Browne really captured the essence of Modern Portfolio Theory. It’s like in chemistry—I can take very volatile elements like sodium and chlorine. By themselves, sodium is quite explosive and chlorine is toxic, but if you mix them together you get salt, which is benign. It’s kind of the same thing with this portfolio. You take different components that by themselves are extremely volatile, but when you put them together the result is actually low volatility.

A lot of people don’t understand that. They want to look at each asset in isolation, and I was guilty of that initially, too. When I first read about the 25% gold, I thought Browne was nuts, and then I read about 25% long-term bonds and I thought he was really nuts. But I have looked at it every way, and I’ve looked into every criticism, because my own money is at stake. But what I have decided over the years is that I sleep like a baby following this strategy.

This whole idea about the US and the debt crisis—everybody is writing me about it, and I’m telling them to just ignore it. You can’t do anything about it, and you’ve got a 25% slug of gold, so you’re going to be OK. And if everything gets fixed, and the gold goes down, well, you’ve got 25% in long-term bonds that are probably going to do well. So don’t worry about it. That has always been my attitude.

We’ll continue the discussion with Craig Rowland on Friday.

25 Comments

Eric
August 30, 2011 at 2:26 pm

I don’t understand the concept of investing in an asset (gold – cash)) that historically have no real return. For me, each asset class to be held in a portfolio for the long term should be expected to earn a return greater than the inflation rate.

DM
August 30, 2011 at 8:58 pm

I agree. I don’t dispute Craig’s logic but wouldn’t it be better to hold gold mining companies as opposed to a hunk of gold? How closely does the share price performance of the large cap gold mining companies track the gold commodity prices?

@Eric: Most asset allocators would agree with you. However, this really comes down to the idea of not looking at the asset classes in isolation, but rather looking at their role in the portfolio as a whole. The gold and cash are not there for long-term growth, but to play a defensive role in specific economic conditions.

@DM: The short answer to your question is “not that closely.” The spot price of gold and mining companies are positively correlated, but that’s as far as it goes. Again, these stocks will not provide much protection during conditions when gold bullion delivers huge gains.

DM
August 30, 2011 at 10:41 pm

@CCP: That’s been my understanding as well. But I still don’t like the idea of holding gold. Just can’t bring myself to invest in a hunk of metal that doesn’t create value, or pay dividends. And what about currency? If I buy GLD and gold rockets, wouldn’t a lot of the gain for Canadian investors be offset by the depreciation of the US dollar? I’m not certain, but I think the negative correlation between gold and USD is quite strong.

The Dividend Ninja
August 30, 2011 at 11:33 pm

@DM, gold mining companies and the value of bullion have no coorelation, gold mining companies returns are extremely volatile and varied. On the other hand, if you look at the spot price of gold for at least the last 10 years, you would literally be blown away. It wouldn’t even matter what currency you bought gold with:

Having said that, I don’t own gold, and have no intention to own the metal (especially with that chart) – but I thought it was overpriced at $900 an ounce less than three years ago.

Had I invested in Browne’s Portfolio some 18 years ago, when I first read his book, I woud have made a very nice return – but that’s hindsight. Dan and Craig, excellent interview – very interesting! I’ll bet Craig has beat most investor’s returns over the years.

@DM: Yes, there is a significant negative correlation between gold and the US dollar, which is good for US residents using the Permanent Portfolio. But holding GLD would not give you any exposure to the US dollar per se. And there will be periods like 2008 when they both go up together.

To be honest, I am not sure what would be optimal for Canadians, but I assume that one would want exposure to gold in his or her native currency.

thom
August 31, 2011 at 7:05 am

I like the idea of having gold in my portfolio as a way to protect it from myself. Humans might be reasonable creatures, but in a panic, she reverts back to being simply a monkey again.

Pat
August 31, 2011 at 9:53 am

Dan,

The Perfect Portfolio is a real revelation. Up until now my preference has been the complete potato portfolio but now I’m wondering aftering looking at the PP’s historical returns. Plus the idea behind the PP makes sense. Has anyone else confirmed Craig’s PP historical return numbers and are you considering doing that? I’m also interested in your take on the PP, for instance if there are any reasons it may not be as successful in the future. Also, are you considering posting a low-cost model PP for Canadians? That’s alot of questions, if you had time for one of them I’d be grateful. And thanks for your excellent blog, it’s made a big difference in my being able to become a DIY investor.

I trust the PP”s historical returns, but I still have reservations about the PP. I believe there are better ways to build a diversified portfolio. I’ll do a post about this next week, after Part 2 of my interview with Craig.

Eric
August 31, 2011 at 10:58 am

Gold is a proven method of preserving value when a national currency is losing value.The US dollar has been trending lower for many decades. Gold is a good option for US investors; it is similar to a financial insurance policy. But the opposite is true when the US dollar rose. During the period from 1995 to 2001, the US dollar was strong and gold was at its lowest level.

The Can dollar is strong, we should invest in international stocks, not gold.
…btw it took 25 years for gold to recover from the late 70’s .

@Chris B: Rebalancing (either annually or when certain thresholds are reached) is definitely an important part of the PP strategy. See the next article in the series, and the comments, for more on this idea.

Gold does not perform like stocks and bonds in terms of internal rate of return. That is true. But it also doesn’t have the same risks as stocks and bonds and this is useful at times. I believe strongly that portfolios should have two parts best described as another reader as a “make money” and “have money” side of things. The stocks and bonds are the “make money” side of the portfolio. Dividends and interest can really drive growth at times. Yet when markets are not doing well you need to fall back on the “have money” side of a portfolio to ride things out. That’s where the gold and cash come in. They are usually two assets that you want when stocks and bonds are doing poorly. If you use gold in a balanced and diversified portfolio holding stocks and bonds it can boost returns and lower volatility.

@DM

Gold mining companies are much different than physical gold bullion. In 2008 for instance mining companies sunk in value around -70%! Gold was up +5% or so. Big difference in performance. Gold mining companies can also sell their gold forward at a certain price so they can’t always take advantage of a strong gold market as they already locked in their price. Finally, a market that is bad for stocks is often bad for all stocks including the miners. Mining is very capital intensive and those companies can have serious problems in a market where stocks are doing poorly overall. In basic terms I like having a portfolio that holds stocks, bonds and hard assets. For me the best hard asset to own is gold because it is a monetary metal and is easy to liquidate as needed to raise capital or rebalance. Other hard assets do not have the complete mix of attributes that gold does in this sense of things.

Re: Couch Potato investing…

I am a couch potato investor. I just mix in gold into my stocks and bonds at the most basic level. The less you touch your investments the better off you’ll be. The more you keep your costs low the better off you’ll be. The more you index your stocks the better off you’ll be. These core couch potato concepts are fundamental for investor success. I just approach the problem with a different asset allocation but the ideas are universal.

My Own Advisor
September 1, 2011 at 8:27 pm

Nice post Dan!

Great details and a nice follow-up to the previous post.

I appreciate Craig’s responses. This portfolio like most well-constructed portfolios are designed to ride all waves.

On the asset allocation side, that allocation to gold does seem through the roof but indirectly I do own some gold, via my index holdings, just not 25% :)

US
September 2, 2011 at 6:34 am

Why not just invest in RRB (Real Return Bonds) or Inflation protected bonds? Isn’t that what the Permanent Portfolio is trying to achieve just a more complex?

BTW – I fully agree with The Dividend Ninja and Eric about gold. I wouldn’t touch it either as an “investment”. Sure, a 1 oz gold coin has value ($50 printed right on it) but no more, unless you are a coin collector (like I), then a silver or gold coin is worth face value + condition + rarity. As a coin collector I’d NEVER pay $1800 for a $50 coin.

Craig Rowland
September 2, 2011 at 12:45 pm

@US Real Return Bonds/TIPS will perform poorly under deflation. They also are very unlikely to provide 3-5% real return under a variety of economic environments. In the event of very high inflation I feel that gold will beat them decisively.

re: Gold Prices – I hear you. But I heard the same thing when gold was $600, 900, 1000, and 1300 an ounce. I don’t know where the price is going. The only thing I tell people is to make sure you are rebalancing your portfolio when you hit the investment bands.

Finally, the portfolio limits exposure to catastrophic loss because the division of assets is 25% in each. So having an asset like gold dive by 50% in value would mean a -12.5% loss to the portfolio. Not great, but not a life changing loss for most. That also assumes that no other asset like stocks or bonds goes up in value to offset those losses which historically has not been the case. Not saying it won’t happen, but just that if the gold market collapses that money has to go somewhere and it’s probably going to go either into your stocks or bonds and this will cushion the loss. Gold took huge losses in the early 1980’s for the portfolio and it took very small losses (-4-6% in 1981) or posted gains for the year because the other assets went up a lot in value.

I think this split of assets is far safer than other portfolios that concentrate bets in assets that one may think will outperform. In 2008 I know people that took -30+% losses in their portfolios due to stock heavy allocations. The Permanent Portfolio had around a +1-2% gain. Yes the stocks lost around 40% along with everyone else, but the other assets wiped out those losses. This is why I advise people not to look at assets in isolation. Only total portfolio performance matters.

The Dividend Ninja » The Weekly Lineup: End of Summer Edition
September 3, 2011 at 4:49 pm

RE: TIPS. In the 1940’s the US treasury indicated they would massage prices to mainatin something like a 2% yield on 10 years. The sheer mention of that had the market price 10 year T’s to those yields. Despite inflation soaring to double digits amounts in some years, 10 year T’s yields stayed low. TIPS would have been good to have held over that period had they been available. In severe deflation, TIPS also repay at least par, so in a -18% deflation type situation, TIPS might be considered as having gained 18%.

Harry Browne devised the PP to diversify out of heavy gold holdings after strong gains in gold in the 1970’s/80’s. I don’t know the exact details but in effect reducing down from 100% gold to 25% gold as a consequence (diversifying into stocks, LTT’s and cash). It would have been good (with hindsight) for an all stock investor to have done similar in the late 1990’s and diversify out of 100% stocks into 25% stocks.

All large and hard declines have been precursored with hard and fast large gains. Wall Street Crash had the roaring 20’s. Japan’s runaway 1980’s saw the subsequent crash of the 1990’s (the peak of the 1989 is still way above current levels). 1980’s/1990’s stock surge and subsequent dot com bubble burst …etc. Gold has seen near 20% annualised compound gains since 2000. That is a potential indicator that a bubble may be forming/formed. Not to say that bubbles can extend up much further than you might expect, so there may still be considerable upside in gold still yet to come. Ultimately however there is a risk that later lows might be lower than present gold price levels.

Generally however the PP rides through such individual asset extremes relatively well. But not always. Japan 1989 to 2002 for instance had their PP barely keep up with inflation, and if a retiree was also drawing an income then they would have endured real losses that might have compounded down to critical levels.

Have a read through that UK web site detail (disclosure its my web site). Specifically how not going all-in on the PP but instead combining the PP with a long/short dated treasury barbell can provide additional safety for only modestly less reward.

There’s a context not mentioned in this article that I think is worth making explicit. The assumption is apparently that the purpose of investment is asset preservation rather than asset growth. If that’s what you’re looking for this sounds fairly interesting. If you want to actually grow your money it makes little to no sense. Then again if all you’re looking for is asset preservation then why not simply invest in permanent Life Insurance, you’ll have a guaranteed positive return, good liquidity and no real worries.

On the flip side I’d understand if someone wanted to preserve their capital rather than grow it if it was that difficult to grow it but the reality is its not, the question is just do you have enough to justify the effort in growing it or should you forget about all this nonsense and focus on making more?

– If we could get a guarantee that future asset returns would be the same as past asset returns, then all long-term investors should be 100% in small-cap value stocks, as these were by far the best performers over the last century. Unfortunately, we have no guarantees. Bonds and stocks have delivered approximately the same returns over the last 40 years, for example, something no one would have predicted in 1970. Since we cannot know the future, we diversify.

– Investors expect to use their money for a specific goal, such as paying for a child’s education or funding retirement. The goal is not usually “to earn the highest return possible, regardless of the risk.” Personally, I intend to use my savings while I’m alive, so a permanent life insurance policy won’t help with that.

– Investors are human beings with an emotional attachment to money. We can do our best to understand cognitive biases and avoid them, but that does not mean we should pretend that everyone can invest like a computer. It is perfectly rational to diversify in order to lower volatility if you think that will help you stick to your investment plan, even if that means sacrificing some upside.

– Glad to hear we can agree the purpose of investing is the growth of capital not merely preservation (except in so far as preservation is a necessary part of growth),if we accept this assumption I’d argue the first most important thing is to understand the real costs of investing to identify what we need in order to be truly positive. The three principle costs being: inflation (historically averaging 3.26% in Canada, the actual rate might be slightly different but it’s arguably a decent benchmark to stay ahead of in the long term); taxes (this is one of the principle reasons I mention life insurance as the tax free growth requires a significantly lower rate of return just to match a taxed equivalent); and finally fees (in my opinion one of the best ways to increase rate of return is often simply to reduce fees since this is a 100% guaranteed return as opposed to an anticipated return), realistically this means somewhere between 4.3% – 9.5% (depending on tax rate and fees is about a minimum break-even) point (slightly lower if you’re in a tax sheltered vehicle but the likelihood of having a significant portfolio worth managing in such a vehicle is limited for most people). When we consider fees we need to consider the impact of our money churning and the negative compounding effect this has, for example where sales fees and commissions are considered each time we buy and sell, trade, etc. we are losing value at a compounded rate, we also pay taxes based on those gains further undermining our returns, all reasons it is optimal to make long term rather than short term investment decisions (if you do the math you’ll find very often the costs of churn undermine the gains of getting into a supposedly better investment when measured repeatedly over time

– the key as I see it is not to look at past performance to determine future performance but rather to anticipate long term value (arguably difficult within funds as compared with stocks), this does require an understanding of valuation as well as long term viability (all of this depends of course on your time horizon), if your investments are based on those two sound principles you’ll likely find over the long term you experience less volatility and less risk and require less churn in the portfolio, the problem with bonds is their underlying value over the long term is fixed (bond funds are of course somewhat different but you immediately introduce management risk and the like into their equation with the associated fees), the same is fundamentally true if you consider investing in mortgages vs. underlying real estate in the case of the former the underlying value remains fixed (sure it can be traded in the short term but that’s a speculative game) while the later has an underlying value that is going to rise over the long term; am I saying bonds are a bad idea? Not necessarily, it depends on your time horizon but long term it’s more difficult to see the underlying potential of bonds

– Regarding permanent life insurance at least assuming you pick the appropriate product you have a high degree if not full degree of use during your lifetime, it doesn’t require that you die to use the money or the growth, only the death benefit portion; I’d suggest taking a look at it as an option, I personally don’t see it as a highly effective investment on its own but to form a portion say 5-10% of a portfolio (depending on the size of the portfolio) it can offer a degree of underlying security, stability, and liquidity tax free

– Good point on volatility as related to sticking with an investment plan, my question to you would be do you believe people actually look at their portfolio as a whole and make decisions accordingly or do they look at volatility within individual investments and act rashly? I don’t have an answer to that question and it obviously varies from individual to individual but in general the premise of your argument seems to be that they don’t focus on the parts but rather on the whole, do you believe that’s an accurate assumption? Volatility is not risk, volatility is volatility, and though it undermines returns to some extent volatility isn’t necessarily a problem if one is taking a long term investment view, I wonder whether it isn’t following the market day to day as opposed to lack or presence of diversification that causes people to act rashly?

@Michael: Yes, the hurdles facing investors are formidable: inflation, taxes and investing costs. We can’t do anything to stop inflation, so minimizing taxes and costs is paramount, as is reducing self-destructive behaviour.

Re: your question: “Do you believe people actually look at their portfolio as a whole and make decisions accordingly or do they look at volatility within individual investments and act rashly?” Unfortunately, I think more people do the second. There is of course a difference between volatility and risk of long-term losses, but humans find it very difficult to think further ahead than two or three years, at least based on my discussions with financial advisers.

I do know disciplined investors whose long-term investments are 100% stocks because they are not bothered by volatility. But these are pretty rare. Part of being a good investors is figuring out your true risk tolerance early on, before you make a dumb mistake with a large amount of money.